A Pragmatic Proposal for Supplier Compensation

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The European Commission has proposed that independent aggregators should not be required anymore to pay compensation to suppliers, as is the case in many EU member states today. According to Philip Baker this proposal should be supported, as it will improve the flexibility of the market and lead to lower prices for consumers. However, it may not be appropriate in the long term: once it has achieved its goals, the issue of compensation should be revisited. 

Explicit demand response is a process in which third-party aggregators pay domestic and smaller commercial customers to flex their demand. It provides these consumers with a low-risk, automated path to market participation. It also helps to ease the integration of intermittent wind and solar generation, and reduce or delay the need for network investment associated with electrifying the heat and transport sectors.

In addition to smoothing the transition to a low-carbon future, explicit demand response can deliver an immediate and beneficial impact on customer’s electricity bills. By reducing demand during periods when capacity is scarce and wholesale prices are high, demand response reduces overall market costs thereby benefiting all consumers in the form of lower electricity bills, not just those who participate. Analysis suggests that even a modest application of demand response could generate savings of up to €1.6 billion annually across the German/Austrian, Nordic, and French electricity markets alone, with greater savings expected across Europe as a whole.

However, despite these benefits and the need to encourage customers to be more flexible, significant barriers to the successful development of aggregated demand response exist. In many Member States, aggregators are required to obtain permission from the customer’s supplier to operate on a customer’s load and to compensate the supplier for lost income. These requirements undermine the already fragile economics of explicit demand response, particularly in the domestic sector, and should be removed.

The Commission’s pragmatic proposals

The European Commission has proposed, in Article 17 of the Clean Energy Package Electricity Directive, which it presented on 30 November 2016, that aggregators should no longer be required seek permission from a customer’s supplier and that they should not be required to pay compensation to suppliers. This proposal is very much to be welcomed. While aggregators do not need to recover fuel costs, they do face significant capital costs in setting up explicit demand response programs, operating costs, and also need to pay participating customers. Given present market conditions, where highly restrictive price caps are often applied, forcing aggregators to compensate suppliers directly would undermine the economics of aggregation and significantly constrain its development.

The Commission’s proposal is a pragmatic response to this situation. It promotes the development of aggregation to ensure that all consumers have the opportunity to share in the associated benefits, while recognising that suppliers have the option of “self-compensating,” i.e., retaining some of reduction in wholesale prices before passing the remaining benefits on to consumers in the form of lower retail rates.

Anticipating the impact of wholesale market reform

The response to the Commission’s proposal has been mixed. The proposals are clearly helpful to the aggregator community, however suppliers are understandably concerned about not being able to recover the cost of energy that they may have bought up-front, but which they cannot bill to consumers who have opted not to consume that energy.

These concerns are not without justification. While the proposal that aggregators should not be required to compensate suppliers is appropriate in the prevailing circumstances, this may not be the case going forward. The Commission’s welcome proposals for wholesale market reform set out in the Clean package will, once implemented, substantially raise or remove price caps and ensure that wholesale energy prices more closely reflect the value that customers place on uninterrupted supply. Aggregated demand response will clearly benefit from periods of higher and more volatile energy prices, and market reform should significantly improve its profitability.

Therefore, once market reform has been introduced and aggregators, acting on behalf of customers, can access wholesale prices that reflect the true value of the demand response services they provide, it will become appropriate to revisit the issue of compensation. At that point, the question will become what level of compensation is appropriate?

Compensation set too low could over-stimulate demand response, at some point resulting in costs to non-participating consumers that exceed the benefits; compensation set too high could reward uneconomic behaviour by suppliers and suppress cost-effective demand-side resources. Given that the timing and extent of market reform will vary across jurisdictions, determining when to revisit the issue of compensation and what compensation should apply, are decisions best left to individual Member States.

A suggested amendment to the Commission’s proposal

Therefore, in order ensure that the Commission’s proposals for supplier compensation are consistent with the other market reforms called for by the Clean Energy Package, we suggest that a sunset clause should be applied to the current wording of Article 17 paragraph 3d of the Electricity Directive, which says that aggregators shall not be required to pay compensation to suppliers or generators. This would allow Member States to revisit the issue of compensation once market reform had been fully implemented or, alternatively, when it was considered that aggregated demand response was sufficiently developed or its economics sufficiently robust.

Once either of these two criteria has been satisfied, the goal of maximizing economic efficiency seems best achieved by linking compensation to the average year-ahead or seasonal wholesale energy price. This should both approximate the purchasing costs incurred by competent suppliers while rewarding aggregators and their customers roughly in line with the net benefits that price-responsive demand would realize. This approach has the added benefit of striking a fair balance between suppliers’ legitimate interest in being compensated and the intractable question of determining exactly what costs were incurred in any given case.

An additional safeguard to ensure the appropriate but not excessive deployment of aggregated demand response might be to include a net benefits test. This would compare the benefits of aggregated demand response seen by customers in the form of reduced wholesale energy prices with the market revenues seen by aggregators. If the latter exceeded the former, this would suggest that the introduction of direct aggregator to supplier compensation was justified. This would to some extent mirror the arrangements introduced by FERC (Federal Energy Regulatory Commission) in the United States, where explicit demand response is also subject to a cost benefit test.

In conclusion, we believe that Commission’s stance that aggregators should not be required to compensate suppliers directly is appropriate, given prevailing market conditions. But once the wholesale market has been reformed in line with the Commission’s proposals set out in the Clean Energy Package, demand response will become a far more profitable enterprise, so compensation should be allowed again.

A version of this blog was originally published by EnergyPost.

European Council set to wipe out energy efficiency progress, leading to a decade of higher energy costs

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Saving energy saves money, improves security, lowers emissions, and makes it easier to meet renewable energy and climate goals. That’s why energy efficiency is the sensible foundation for the Energy Union and the 2030 Clean Energy Package now under review: deeper savings make the rest of the goals so much easier to achieve. They will also generate considerable additional social, economic and health benefits. It is shocking, then, to learn that amendments now being considered in the European Council could weaken that foundation to the point of collapse.

In November last year, the European Commission’s Clean Energy Package proposed a 30 percent energy efficiency target for 2030. Given that the EU is on track to achieve 24 percent savings by 2030, and that deeper savings are both widely available and cost-effective, experts noted that saving just 6 percent more is a very modest goal. This is why the European Parliament called for a 40 percent target in June last year. There was an expectation that the compromise reached might end up somewhere between 30 percent and 40 percent.

Going backwards on energy efficiency

This was, as it turns out, wishful thinking, at least in this Council. Several Member States are pushing for even weaker targets. A vote on this is expected for next Monday. In particular, proposals are being prepared to water down the provisions in Article 7 of the Energy Efficiency Directive (EED), which delivers about half of the entire savings of the Directive and is a key driver for energy efficiency in Europe.

Current proposals circulated in the European Council introduce a range of new loopholes:

  • Double counting all energy savings from new buildings standards/codes even though those are covered by the Energy Performance in Buildings Directive already;
  • Double counting savings towards the period 2021-2030 from energy efficiency measures installed before 2021 with lifetimes longer than 23 years as if they were new savings;
  • Allowing 15 percent of on-site renewable energy generation to be treated as energy savings; and
  • Allowing excess savings from the current Article 7 period 2014-2020 to lower the minimum savings 2021-2030.

As is often the case with legislative loopholes, their impacts are not immediately obvious, but an informed review reveals that they will greatly weaken key features of the EED.

If accepted, those proposals will reduce the current ambition levels by more than 80 percent and perhaps as much as 100 percent depending on the amount of excess savings and how Member States apply these proposed terms. The figure below summarises the impact of introducing the proposed new loopholes.

Proposals reduce ambition levels by 80 to 100 percent

Proposed Loopholes Wipeout Efficiency Ambition

Source: RAP analysis based on EC (2016a), EC (2016b), Ricardo et al. (2016), and data from Buildings Observatory. Mtoe = million tons of oil equivalent

As this simple review reveals, the amendments being considered in the Council (excluding excess savings) will reduce the actual energy savings mandate in the EED from an effective level of 443 Mtoe per year to just 52 Mtoe—a reduction of almost 90 percent. Depending on the amount of excess savings reported by Member States in 2014 and 2015 the total savings target is currently on track to be less than 0 Mtoe.

Even a very optimistic estimate suggests a reduction of the current ambition level by around 80 percent to 92 Mtoe. This assumes very little excess savings, only a small amount of renewable energy being counted, and more efficient new buildings in the absence of building codes than assumed.

This flies in the face of the impact assessment by the European Commission which shows that more ambitious efficiency targets deliver greater benefits for consumers and the economy. Such diluted energy efficiency targets will raise energy bills, raise energy imports, and raise the cost of meeting the commitments that Europe has made to the world in Paris.

Long-term ambitious targets needed to provide investor confidence

Ambitious and firm targets are important for investors. More than 400 individuals attended the Energy Efficiency Finance Market Place conference that took place in Brussels in January, including major banks, pension funds and insurance companies. There was unanimous agreement that lack of capital is no barrier to more energy efficiency. To the contrary, speakers agreed that there are substantial amounts of capital well-suited for investment in energy efficiency. The most important point from the perspective of financiers was a long-term stable policy framework for energy efficiency. This includes an ambitious energy efficiency target and a continuation of Article 7 at least at 1.5 percent.

Consumers reap the benefits from strong energy efficiency policies

Consumers benefit directly from effective energy efficiency policies. This is because the cost of saving energy is far below the cost of consuming it. The most comprehensive data on the investment requirements of measures promoted by Article 7 of the Energy Efficiency Directive can be found for energy efficiency obligations (EEOs), the instruments that provide the largest share of the savings. A review of all EEOs in Europe where data exists demonstrates high cost-effectiveness.

In the case of all five EEOs analysed, the data clearly show that the cost of negawatt-hours is much lower than that of megawatt-hours. Even if the contributions from those who benefit from the programme to the investment cost of efficiency measures are added (which is typically about one to two times as much as the programme cost), the cost per kWh even in the most “expensive” programme is just below 3 eurocents/kWh. This compares to an average cost of supplied energy of 10 eurocents/kWh.

Energy Efficiency Costs Less Than Supplied Energy

Energy Efficiency Costs Less Than Supplied Energy

Source: Rosenow and Bayer (2017)

Data for alternative measures such as loans, tax rebates, and grants shows that the programme costs of those measures are of a similar scale, although somewhat higher. On average, saving 1 kWh through those measures has a public cost of 1.4 eurocents/kWh.

Can we be confident that this data is reliable? We can: It is in line with the most recent data from the De-Risking Energy Efficiency Platform (DEEP) database, which contains close to 6,000 individual energy efficiency projects across the Member States of the EU. Overall, the costs per kWh saved in buildings are 2.5 eurocents and in the industry sector 1.2 eurocents.

Power system savings benefit all customers

Lowering demand at the customer end of the power system lowers costs at every link in the power system. These benefits, often overlooked in Europe, include avoided transmission and distribution costs, avoided line losses, and minimisation of reserve requirements. In competitive power markets, lower demand also means lower clearing prices for power, which reduces per-kwh charges for all customers. A recent study exploring the scale of system benefits in Europe affirms what international experience has demonstrated for a long time—comprehensive, long-term, and aggressive investment in end-use energy efficiency will yield substantial energy system cost savings. The value of electricity savings in Germany to the power system alone is in the range of 0.11–0.15 eurocents per kilowatt-hour saved.

End use efficiency also has the benefit of being available exactly when it is needed. Unlike power generation, which must be managed to line up with energy demand, efficiency is automatically “on” whenever the lights are on, or the motors are turning—provided of course, that we have bothered to ensure that the equipment was efficient in the first place.

Efficiency delivers multiple, wide-ranging benefits

In addition to bill savings and system cost savings (the most obvious benefits of energy efficiency improvements), energy efficiency delivers a wide range of so-called “non-energy” benefits to consumers and society. Amongst those are improvements in health, comfort, air quality, public housing and welfare costs, job creation, and economic growth. Energy efficiency (and the resulting demand reduction) also delivers substantial environmental benefits in terms of CO2 mitigation.

Efficiency provides the foundation for the Clean Energy package

Decades of experience across more than 50 nations, states, and provinces reveals that disciplined energy efficiency programs like those created under the EED are the lowest-cost, most widely-available, and most reliable way to reduce CO2 emissions while we build the new energy systems needed in a low-carbon economy. But energy companies don’t naturally invest in efficiency, and efficiency programs do not spring into being on their own—governmental support is required. That is why the EED is so important.  Europe’s entire Clean Energy package will be less expensive, more reliable, and easier to achieve if it begins with a strong foundation of energy savings. Undermining that foundation with weak savings targets in the EED is a major backwards step for the European Union.

A version of this blog was originally published by Energy Post

Proposed Electricity Directive a Step in the Right Direction for Customers, Demand Response

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Explicit demand response, where aggregators enable small commercial and domestic consumers to directly participate in the wholesale power market by flexing their demand, is a vital resource in the transition to a sustainable electricity system. However, barriers to the successful development of this vital resource exist in many Member States, including the need for aggregators to obtain permission from the customer’s supplier and to compensate the supplier for lost income.

As the potential for demand response is significant and the savings likely exceed associated costs by a considerable amount, we should be doing everything we can to tear down barriers and open markets to this customer-centric resource. Article 17 of the European Commission’s proposed Electricity Directive is a positive step in this direction and should be widely supported. It ends the requirement for an aggregator to obtain permission to operate on a consumer’s demand or to compensate the consumer’s supplier (other than in some imbalance-related “exceptional circumstances”).

Unfortunately, incumbent suppliers are pushing back on the Commission’s proposal, maintaining that energy they purchase up front is transferred to aggregators free of charge, who then profit by selling it on, leaving suppliers unable to bill customers for unused energy. In reality, this is not the case and obfuscates the tangible benefits that aggregated demand response delivers. More details on the following discussion are available in the accompanying policy brief, Unleashing Demand Response with Effective Supplier Compensation.

Aggregators Help Customers Reduce Demand, Avoid Expensive Generation Costs

The services provided by demand response aggregators simply allow an energy supplier’s customers to reduce their demand. When the aggregator offers this product to the wholesale energy market, it removes the need to generate an equivalent amount of energy. As no more energy can be generated than is consumed, the aggregator’s product reduces the amount of energy generated and, hence, market costs. No energy is transferred; it is simply not used.

Figure 1 shows that even modest reductions in demand can avoid the need to run high-marginal-cost generation or other more costly measures, reducing market clearing prices. This allows suppliers to make significant savings when buying energy for their customers, and one would expect that most of these savings will make their way to customers through competitive or, where necessary, regulatory pressure. The point to note here is that all customers benefit from cost-competitive demand response, not just those customers who reduce their demand. It is a genuine societal benefit in the form of lower wholesale and retail energy prices and avoidance of uneconomic investment.

Explicit Demand Response Reduces Wholesale Electricity Prices

Figure 1. Explicit Demand Response Reduces Wholesale Electricity Prices

As suppliers cannot bill customers for energy not consumed, they are demanding additional compensation from aggregators to recover the lost revenue associated with explicit downward demand response. In the case where customers simply reduce consumption in response to price signals delivered through a time-of-use or dynamic tariff (price-based or implicit demand response), there is no suggestion that those customers should compensate the supplier for loss of revenue. However, requiring aggregators to compensate suppliers for lost revenue essentially amounts to the same thing.

Similar Debate in the US

Order 745 of the Federal Energy Regulatory Commission (FERC) in the U.S. requires wholesale market operators to pay the same wholesale price to providers of demand response as is paid to generators—essentially the same situation as exists in European markets today. No discount or supplier compensation is applied. Order 745 contains a “net-benefit” test to ensure that a demand response provider only receives the full market value if there is an overall benefit to consumers. This is a precaution the Commission may want to consider if it believes the “no-compensation” position set out in Article 17 of the proposed directive could lead to excessive demand response deployment.

Simple, Straight-Forward Alternative to Supplier Compensation

Last fall, I suggested an alternative to the complex and unfair practice of requiring demand response aggregators to pay energy suppliers for unused energy. Under this approach, suppliers retain a small portion of the wholesale market savings, which should always exceed, and often dwarf, any income lost by suppliers due to customers opting not to consume.

Relying on the retention of some of these wholesale market savings to ensure that suppliers remain financially whole rather than via negotiated or administered compensation is both a pragmatic and just solution. The alternative of direct compensation proposed by suppliers will significantly hinder the development of implicit demand response, resulting in fewer benefits to be enjoyed in the first place. Furthermore, as the reduction in wholesale energy prices brought about by demand response should be enjoyed by all customers via lower retail tariffs, it seems appropriate that all customers should share in the associated costs and not just the providers of that demand response. The proposal also has the virtue of simplicity, with no negotiation between aggregators and suppliers and no need to make the difficult assumptions necessary in establishing an administered alternative to negotiation, with the attendant risks of over– or under–compensation.

Article 17 of Proposed Electricity Directive Removes Barriers to Demand Response

In its current form, Article 17 removes a significant barrier to the development of explicit demand response and the enhanced customer market participation and flexibility so necessary to a cost-effective transition to a low-carbon electricity system. Any modification of the current wording to require aggregators to compensate suppliers for income associated with energy not consumed, would undermine these aims.

Photo Credit: Consumers Energy